Related Parties - AICPA

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Related Parties 771 AU-C Section 550 Related Parties Source: SAS No. 122; SAS No. 128; SAS No. 135; SAS No. 136. Effective for audits of financial statements for periods ending on or after December 15, 2012, unless otherwise indicated. Introduction Scope of This Section .01 This section addresses the auditor's responsibilities relating to re- lated party relationships and transactions in an audit of financial statements. 1 Specifically, it expands on how section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement; section 330, Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained; and section 240, Consideration of Fraud in a Finan- cial Statement Audit, are to be applied regarding risks of material misstate- ment associated with related party relationships and transactions. .02 Section 700, Forming an Opinion and Reporting on Financial State- ments, and section 703, Forming an Opinion and Reporting on Financial State- ments of Employee Benefit Plans Subject to ERISA, as applicable, requires the auditor to evaluate whether the financial statements achieve fair presenta- tion. 2 Section 800, Special Considerations — Audits of Financial Statements Prepared in Accordance With Special Purpose Frameworks, requires that, in audits of special purpose financial statements that contain related party trans- actions, the auditor evaluate whether the financial statements include infor- mative disclosures similar to those required by generally accepted accounting principles (GAAP). 3 Section 800 also requires the auditor to evaluate whether additional disclosures beyond those specifically required by the framework and related to matters that are not specifically identified on the face of the financial statements or other disclosures may be necessary for the financial statements to achieve fair presentation. 4 Thus, this section applies to all audits of financial statements. (Ref: par. .A1–.A3) [As amended, effective for audits of financial statements for periods ending on or after December 15, 2021, by SAS No. 136.] 1 The phrase "related party relationships and transactions" as used in generally accepted audit- ing standards is intended to have the same meaning as the phrase "related parties and relationships and transactions with related parties" as used in the auditing standards of the PCAOB. [Footnote added, effective for audits of financial statements for periods ending on or after December 15, 2021, by SAS No. 135.] 2 Paragraph .16 of section 700, Forming an Opinion and Reporting on Financial Statements, and paragraph .41 of section 703, Forming an Opinion and Reporting on Financial Statements of Employee Benefit Plans Subject to ERISA, as applicable. [Footnote renumbered by the issuance of SAS No. 135, May 2019. As amended, effective for audits of financial statements for periods ending on or after December 15, 2021, by SAS No. 136.] 3 Paragraph .17 of section 800, Special Considerations — Audits of Financial Statements Prepared in Accordance With Special Purpose Frameworks. [Footnote renumbered by the issuance of SAS No. 135, May 2019.] 4 Paragraph .17 of section 800. [Footnote renumbered by the issuance of SAS No. 135, May 2019.] ©2021, AICPA AU-C §550.02

Transcript of Related Parties - AICPA

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AU-C Section 550

Related Parties

Source: SAS No. 122; SAS No. 128; SAS No. 135; SAS No. 136.

Effective for audits of financial statements for periods ending on orafter December 15, 2012, unless otherwise indicated.

Introduction

Scope of This Section.01 This section addresses the auditor's responsibilities relating to re-

lated party relationships and transactions in an audit of financial statements.1Specifically, it expands on how section 315, Understanding the Entity and ItsEnvironment and Assessing the Risks of Material Misstatement; section 330,Performing Audit Procedures in Response to Assessed Risks and Evaluating theAudit Evidence Obtained; and section 240, Consideration of Fraud in a Finan-cial Statement Audit, are to be applied regarding risks of material misstate-ment associated with related party relationships and transactions.

.02 Section 700, Forming an Opinion and Reporting on Financial State-ments, and section 703, Forming an Opinion and Reporting on Financial State-ments of Employee Benefit Plans Subject to ERISA, as applicable, requires theauditor to evaluate whether the financial statements achieve fair presenta-tion.2 Section 800, Special Considerations — Audits of Financial StatementsPrepared in Accordance With Special Purpose Frameworks, requires that, inaudits of special purpose financial statements that contain related party trans-actions, the auditor evaluate whether the financial statements include infor-mative disclosures similar to those required by generally accepted accountingprinciples (GAAP).3 Section 800 also requires the auditor to evaluate whetheradditional disclosures beyond those specifically required by the framework andrelated to matters that are not specifically identified on the face of the financialstatements or other disclosures may be necessary for the financial statementsto achieve fair presentation.4 Thus, this section applies to all audits of financialstatements. (Ref: par. .A1–.A3) [As amended, effective for audits of financialstatements for periods ending on or after December 15, 2021, by SAS No. 136.]

1 The phrase "related party relationships and transactions" as used in generally accepted audit-ing standards is intended to have the same meaning as the phrase "related parties and relationshipsand transactions with related parties" as used in the auditing standards of the PCAOB. [Footnoteadded, effective for audits of financial statements for periods ending on or after December 15, 2021,by SAS No. 135.]

2 Paragraph .16 of section 700, Forming an Opinion and Reporting on Financial Statements, andparagraph .41 of section 703, Forming an Opinion and Reporting on Financial Statements of EmployeeBenefit Plans Subject to ERISA, as applicable. [Footnote renumbered by the issuance of SAS No. 135,May 2019. As amended, effective for audits of financial statements for periods ending on or afterDecember 15, 2021, by SAS No. 136.]

3 Paragraph .17 of section 800, Special Considerations — Audits of Financial Statements Preparedin Accordance With Special Purpose Frameworks. [Footnote renumbered by the issuance of SAS No.135, May 2019.]

4 Paragraph .17 of section 800. [Footnote renumbered by the issuance of SAS No. 135, May 2019.]

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Nature of Related Party Relationships and Transactions(Ref: par. .A1–.A6)

.03 Many related party transactions are in the normal course of business.In such circumstances, they may carry no higher risk of material misstatementof the financial statements than similar transactions with unrelated parties.However, the nature of related party relationships and transactions may, insome circumstances, give rise to higher risks of material misstatement of thefinancial statements than transactions with unrelated parties. For example

• related parties may operate through an extensive and complexrange of relationships and structures, with a corresponding in-crease in the complexity of related party transactions.

• information systems may be ineffective at identifying or summa-rizing transactions and outstanding balances between an entityand its related parties.

• related party transactions may not be conducted under normalmarket terms and conditions (for example, some related partytransactions may be conducted with no exchange of considera-tion).

• related party transactions may be motivated solely or in largemeasure to engage in fraudulent financial reporting or concealmisappropriation of assets.

Responsibilities of the Auditor.04 Because related parties are not independent of each other, financial re-

porting frameworks establish specific accounting and disclosure requirementsfor related party relationships, transactions, and balances to enable users of thefinancial statements to understand their nature and actual or potential effectson the financial statements. Therefore, the auditor has a responsibility to per-form audit procedures to identify, assess, and respond to the risks of materialmisstatement arising from the entity's failure to appropriately account for ordisclose related party relationships, transactions, or balances. (Ref: par. .A3)

.05 In addition, an understanding of the entity's related party relation-ships and transactions is relevant to the auditor's evaluation of whether one ormore fraud risk factors are present, as required by section 240, because fraudmay be more easily committed through related parties.5

.06 Owing to the inherent limitations of an audit, an unavoidable risk ex-ists that some material misstatements of the financial statements may not bedetected, even though the audit is properly planned and performed in accor-dance with generally accepted auditing standards (GAAS).6 In the context ofrelated parties, the potential effects of inherent limitations on the auditor'sability to detect material misstatements are greater because of reasons suchas the following:

• Management may be unaware of the existence of all related partyrelationships and transactions.

5 Paragraph .24 of section 240, Consideration of Fraud in a Financial Statement Audit. [Footnoterenumbered by the issuance of SAS No. 135, May 2019.]

6 Paragraph .A56 of section 200, Overall Objectives of the Independent Auditor and the Conductof an Audit in Accordance With Generally Accepted Auditing Standards. [Footnote renumbered by theissuance of SAS No. 135, May 2019.]

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• Related party relationships may present a greater opportunity forcollusion, concealment, or manipulation by management.

.07 Planning and performing the audit with professional skepticism as re-quired by section 200, Overall Objectives of the Independent Auditor and theConduct of an Audit in Accordance With Generally Accepted Auditing Stan-dards, is, therefore, particularly important in this context, given the poten-tial for undisclosed related party relationships and transactions.7 The require-ments in this section are designed to assist the auditor in identifying andassessing the risks of material misstatement associated with related party re-lationships and transactions and in designing audit procedures to respond tothe assessed risks.

Effective Date.08 This section is effective for audits of financial statements for periods

ending on or after December 15, 2012.

Objectives.09 The objectives of the auditor are to

a. obtain an understanding of related party relationships and trans-actions sufficient to be able to

i. recognize fraud risk factors, if any, arising from relatedparty relationships and transactions that are relevant tothe identification and assessment of the risks of materialmisstatement due to fraud.

ii. conclude, based on the audit evidence obtained, whetherthe financial statements, insofar as they are affected bythose relationships and transactions, achieve fair presen-tation.

b. obtain sufficient appropriate audit evidence about whether re-lated party relationships and transactions have been appropri-ately identified, accounted for, and disclosed in the financial state-ments.

Definitions.10 For purposes of GAAS, the following terms have the meanings at-

tributed as follows:

Arm's length transaction. A transaction conducted on such termsand conditions between a willing buyer and a willing seller whoare unrelated and are acting independently of each other and pur-suing their own best interests.

Related party. A party defined as a related party in GAAP. (Ref: par..A1)

.11 Reference to GAAP in GAAS means generally accepted accountingprinciples promulgated by bodies designated by the Council of the AICPA pur-suant to the "Compliance With Standards Rule" (ET sec. 1.310.001) and the

7 Paragraph .17 of section 200. [Footnote renumbered by the issuance of SAS No. 135, May 2019.]

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"Accounting Principles Rule" (ET sec. 1.320.001) of the AICPA Code of Profes-sional Conduct. [Revised, January 2015, to reflect conforming changes neces-sary due to the issuance of the revised AICPA Code of Professional Conduct,effective December 15, 2014.]

Requirements

Risk Assessment Procedures and Related Activities.12 As part of the risk assessment procedures and related activities that

section 240 and section 315 require the auditor to perform during the audit,the auditor should perform the audit procedures and related activities set outin paragraphs .13–.19 to obtain information relevant to identifying the risks ofmaterial misstatement associated with related party relationships and trans-actions.8, 9

Understanding the Entity’s Related Party Relationships and Transactions.13 In connection with the engagement team discussion(s) that section 240

and section 315 require, the auditor should include specific consideration ofthe susceptibility of the financial statements to material misstatement due tofraud or error that could result from the entity's related party relationshipsand transactions.10, 11 (Ref: par. .A7–.A8)

.14 The auditor should inquire of management and others within the en-tity regarding the following:

a. The identity of the entity's related parties, including changes fromthe prior period (Ref: par. .A9–.A15)

b. The nature of the relationships (including ownership structure)between the entity and these related parties

c. The business purpose of entering into a transaction with a relatedparty versus an unrelated party

d. Whether the entity entered into, modified, or terminated anytransactions with these related parties during the period and, ifso, the type and business purpose of the transactions

[As amended, effective for audits of financial statements for periods ending onor after December 15, 2021, by SAS No. 135.]

.15 The auditor should inquire of management and others within the en-tity and perform other risk assessment procedures12 considered appropriate toobtain an understanding of the controls, if any, that management has estab-lished to (Ref: par. .A16–.A21)

a. identify, account for, and disclose related party relationships andtransactions.

8 Paragraph .16 of section 240. [Footnote renumbered by the issuance of SAS No. 135, May 2019.]9 Paragraph .05 of section 315, Understanding the Entity and Its Environment and Assessing the

Risks of Material Misstatement. [Footnote renumbered by the issuance of SAS No. 135, May 2019.]10 Paragraph .15 of section 240. [Footnote renumbered by the issuance of SAS No. 135, May 2019.]11 Paragraph .11 of section 315. [Footnote renumbered by the issuance of SAS No. 135, May 2019.]12 Paragraph .06 of section 315. [Footnote renumbered by the issuance of SAS No. 135, May 2019.]

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b. authorize and approve significant transactions and arrangementswith related parties. (Ref: par. .A22)

c. authorize and approve significant unusual transactions, and ar-rangements outside the normal course of business.

Inquiries should include asking about any related party transactionsa. that have not been authorized and approved in accordance with

the entity's established policies or procedures regarding the au-thorization and approval of transactions with related parties.

b. for which exceptions to the entity's established policies or proce-dures were granted and the reasons for granting those exceptions.(Ref: par. .A44–.A45)

[As amended, effective for audits of financial statements for periods ending onor after December 15, 2021, by SAS No. 135.]

.16 Unless all of those charged with governance are involved in managingthe entity, the auditor should inquire of those charged with governance (or theaudit committee or, at least, its chair) regarding

a. their understanding of the entity's relationships and transactionswith related parties that are significant to the entity and

b. whether any of those charged with governance have concerns re-garding relationships or transactions with related parties and, ifso, the substance of those concerns.

[Paragraph added, effective for audits of financial statements for periods endingon or after December 15, 2021, by SAS No. 135.]

Remaining Alert for Related Party Information When ReviewingRecords or Documents

.17 During the audit, the auditor should remain alert when inspectingrecords or documents for arrangements or other information that may indicatethe existence of related party relationships or transactions that managementhas not previously identified or disclosed to the auditor. In particular, the audi-tor should inspect the following for indications of the existence of related partyrelationships or transactions that management has not previously identified ordisclosed to the auditor: (Ref: par. .A23–.A25)

a. Bank and legal confirmations obtained as part of the auditor'sprocedures

b. Minutes of meetings of shareholders and of those charged withgovernance and summaries of actions of recent meetings forwhich minutes have not yet been prepared

c. Such other records or documents as the auditor considers neces-sary in the circumstances of the entity

[Paragraph renumbered and amended, effective for audits of financial state-ments for periods ending on or after December 15, 2021, by SAS No. 135.]

.18 If the auditor identifies significant unusual transactions when per-forming the audit procedures required by paragraph .17 or through other auditprocedures, the auditor should inquire of management about the following: (Ref:par. .A26–.A27)

a. The nature of these transactions (Ref: par. .A28)b. Whether related parties could be involved (Ref: par. .A29)

[Paragraph renumbered and amended, effective for audits of financial state-ments for periods ending on or after December 15, 2021, by SAS No. 135.]

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Sharing Related Party Information With the Engagement Team.19 The auditor should share with the other members of the engagement

team the identity of the entity's related parties and other relevant informationobtained about the related parties. (Ref: par. .A30–.A31) [Paragraph renum-bered by the issuance of SAS No. 135, May 2019.]

Identification and Assessment of the Risks of MaterialMisstatement Associated With Related Party Relationshipsand Transactions

.20 In meeting the requirement of section 315 to identify and assess therisks of material misstatement, the auditor should identify and assess therisks of material misstatement associated with related party relationships andtransactions and determine whether any of those risks are significant risks.13

In making this determination, the auditor should treat identified related partytransactions that are also significant unusual transactions as giving rise tosignificant risks. [Paragraph renumbered and amended, effective for audits offinancial statements for periods ending on or after December 15, 2021, by SASNo. 135.]

.21 If the auditor identifies fraud risk factors (including circumstances re-lating to the existence of a related party with dominant influence) when per-forming the risk assessment procedures and related activities in connectionwith related parties, the auditor should consider such information when iden-tifying and assessing the risks of material misstatement due to fraud, in accor-dance with section 240.14 (Ref: par. .A32–.A34) [Paragraph renumbered by theissuance of SAS No. 135, May 2019.]

Responses to the Risks of Material Misstatement AssociatedWith Related Party Relationships and Transactions

.22 As part of the requirement in section 330 that the auditor respondto assessed risks, the auditor should design and perform further audit proce-dures to obtain sufficient appropriate audit evidence about the assessed risks ofmaterial misstatement associated with related party relationships and trans-actions. The auditor should evaluate whether the entity has properly identi-fied its related party relationships and transactions. Evaluating whether anentity has properly identified its related party relationships and transactionsinvolves more than assessing the process used by the entity. The evaluationshould include procedures to test the accuracy and completeness of the relatedparty relationships and transactions identified by the entity, taking into ac-count the information gathered during the audit.15 (Ref: par. .A35–.A38) [Para-graph renumbered and amended, effective for audits of financial statements forperiods ending on or after December 15, 2021, by SAS No. 135.]

13 Paragraph .26 of section 315. [Footnote renumbered by the issuance of SAS No. 135, May2019.]

14 Paragraph .24 of section 240. [Footnote renumbered by the issuance of SAS No. 135, May2019.]

15 Paragraphs .05–.06 of section 330, Performing Audit Procedures in Response to Assessed Risksand Evaluating the Audit Evidence Obtained. [Footnote renumbered by the issuance of SAS No. 135,May 2019.]

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.23 The auditor should perform procedures on balances with affiliated en-tities as of concurrent dates, even if fiscal years of the respective entities differ.The procedures performed should address the risks of material misstatementassociated with the entity's accounts with affiliates. [Paragraph added, effec-tive for audits of financial statements for periods ending on or after December15, 2021, by SAS No. 135.]

Identification of Previously Unidentified or Undisclosed Related Parties orSignificant Related Party Transactions

.24 If the auditor identifies arrangements or information that suggests theexistence of related party relationships or transactions that management hasnot previously identified or disclosed to the auditor, the auditor should deter-mine whether the underlying circumstances confirm the existence of those re-lationships or transactions. [Paragraph renumbered by the issuance of SAS No.135, May 2019.]

.25 If the auditor identifies related parties or significant related partytransactions that management has not previously identified or disclosed to theauditor, the auditor should

a. promptly communicate the relevant information to the othermembers of the engagement team. (Ref: par. .A30 and .A39)

b. request management to identify all transactions with the newlyidentified related parties for the auditor's further evaluation.

c. inquire why the entity's controls over related party relationshipsand transactions failed to enable the identification or disclosureof the related party relationships or transactions.

d. perform appropriate substantive audit procedures relating tosuch newly identified related parties or significant related partytransactions. (Ref: par. .A40)

e. reconsider the risk that other related parties or significant relatedparty transactions may exist that management has not previouslyidentified or disclosed to the auditor and perform additional auditprocedures as necessary.

f. evaluate the implications for the audit if the nondisclosure bymanagement appears intentional (and, therefore, indicative of arisk of material misstatement due to fraud). (Ref: par. .A41)

[Paragraph renumbered by the issuance of SAS No. 135, May 2019.]

Identified Related Party Transactions That Are Required to Be Disclosed orDetermined to be a Significant Risk

.26 For identified significant related party transactions that are requiredto be disclosed in the financial statements or determined to be a significant risk,the auditor should16

a. read the underlying contracts or agreements, if any, and evaluatewhether

16 See paragraph .21, which requires the auditor to treat identified related party transactions thatare also significant unusual transactions as giving rise to significant risks. [Footnote added, effectivefor audits of financial statements for periods ending on or after December 15, 2021, by SAS No. 135.]

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i. the business purpose (or lack thereof) of the transactionssuggests that they may have been entered into to engagein fraudulent financial reporting or to conceal misappro-priation of assets.17 (Ref: par. .A42–.A43)

ii. the terms of the transactions are consistent with manage-ment's explanations.

iii. the transactions have been appropriately accounted forand disclosed.

b. obtain audit evidence that the transactions have been appropri-ately authorized and approved. (Ref: par. .A44–.A45)

[Paragraph renumbered and amended, effective for audits of financial state-ments for periods ending on or after December 15, 2021, by SAS No. 135.]

Assertions That Related Party Transactions Were Conducted on TermsEquivalent to Those Prevailing in an Arm’s Length Transaction

.27 If management has made an assertion in the financial statements tothe effect that a related party transaction was conducted on terms equivalentto those prevailing in an arm's length transaction, the auditor should obtainsufficient appropriate audit evidence about the assertion. (Ref: par. .A46–.A50)[Paragraph renumbered by the issuance of SAS No. 135, May 2019.]

Evaluation of the Accounting for, and Disclosure of, IdentifiedRelated Party Relationships and Transactions

.28 In forming an opinion on the financial statements, in accordance withsection 700, or section 703, the auditor should evaluate the following:18 (Ref:par. .A51)

a. Whether the identified related party relationships and transac-tions have been appropriately accounted for and disclosed (Ref:par. .A52)

b. Whether the effects of the related party relationships and trans-actions prevent the financial statements from achieving fair pre-sentation (Ref: par. .A3)

[Paragraph renumbered by the issuance of SAS No. 135, May 2019. Asamended, effective for audits of financial statements for periods ending on orafter December 15, 2021, by SAS No. 136.]

Communication With Those Charged With Governance.29 Unless all of those charged with governance are involved in managing

the entity, the auditor should communicate with those charged with governancesignificant findings or issues arising during the audit in connection with the en-tity's related parties.19 (Ref: par. .A53) [Paragraph renumbered and amended,effective for audits of financial statements for periods ending on or after De-cember 15, 2021, by SAS No. 135.]

17 Paragraph .32c of section 240. [Footnote renumbered by the issuance of SAS No. 135, May2019.]

18 Paragraphs .12–.17 of section 700, or paragraphs .37–.42 of section 703, as applicable. [Footnoterenumbered by the issuance of SAS No. 135, May 2019. As amended, effective for audits of financialstatements for periods ending on or after December 15, 2021, by SAS No. 136.]

19 Paragraph .09 of section 260, The Auditor's Communication With Those Charged With Gover-nance. [Footnote renumbered by the issuance of SAS No. 135, May 2019.]

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Documentation.30 The auditor should include in the audit documentation the names of

the identified related parties and the nature of the related party relationships.20

[Paragraph renumbered by the issuance of SAS No. 135, May 2019.]

Application and Other Explanatory Material

Nature of Related Party Relationships and Transactions(Ref: par. .02–.04, .10, and .28b)

.A1 GAAP frameworks include or refer to specific disclosure requirementsfor related party relationships and transactions. If the applicable financial re-porting framework does not have specific disclosure requirements, the auditor,nonetheless, evaluates whether related party information is disclosed in a man-ner comparable to GAAP in order for the financial statements to achieve fairpresentation.21

.A2 Certain accounting pronouncements prescribe the accounting treat-ment when related parties are involved; however, established accounting prin-ciples ordinarily do not require transactions with related parties to be ac-counted for on a basis different from that which would be appropriate if theparties were not related. In addition, the substance of a particular transactionmay be significantly different from its form. Accordingly, financial statementsprepared in accordance with GAAP generally recognize the substance of par-ticular transactions rather than merely their legal form.

.A3 Related party relationships and transactions may cause the financialstatements to fail to achieve fair presentation if, for example, the economic sub-stance of such relationships and transactions is not appropriately reflected inthe financial statements. For instance, fair presentation may not be achieved ifthe sale of a property by the entity to a controlling shareholder at a price aboveor below fair market value has been accounted for as a transaction involving aprofit or loss for the entity when it may constitute a contribution or return ofcapital or the payment of a dividend. [As amended, effective for audits of finan-cial statements for periods ending on or after December 15, 2021, by SAS No.135.]

.A4 Transactions that because of their nature may be indicative of the ex-istence of related parties include the following:

a. Borrowing or lending on an interest free basis or at a rate of in-terest significantly above or below market rates prevailing at thetime of the transaction

b. Selling real estate at a price that differs significantly from its ap-praised value

c. Exchanging property for similar property in a nonmonetarytransaction

d. Making loans with no scheduled terms for when or how the fundswill be repaid

20 Paragraphs .08–.12 and .A8 of section 230, Audit Documentation. [Footnote renumbered by theissuance of SAS No. 135, May 2019.]

21 Paragraph .17 of section 800. [Footnote renumbered by the issuance of SAS No. 135, May 2019.]

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.A5 Although many related party transactions are in the normal course ofbusiness, a possibility exists that transactions with related parties may havebeen motivated solely or in large measure by conditions similar to the following:

a. Lack of sufficient working capital or credit to continue the busi-ness

b. An overly optimistic earnings forecast

c. Dependence on a single or relatively few products, customers, ortransactions for the continued success of the venture

d. A declining industry characterized by a large number of businessfailures

e. Excess capacity

f. Significant litigation, especially litigation between stockholdersand management

g. Significant obsolescence dangers because the company is in a hightechnology industry

For these reasons, related party transactions may indicate an increased risk ofmaterial misstatement of the financial statements.

Considerations Specific to Governmental Entities.A6 For state and local governmental entities, related party relationships

and transactions can result from interactions with other governments, not-for-profit entities, for-profit entities, and individuals. The applicable financialreporting framework used by most state and local governmental entities ad-dresses related party relationships and transactions using terms that includerelated parties, related organizations, and component units, and can result inthe inclusion of the related parties' financial statements as a reporting unit,inclusion within a reporting unit, disclosure of the related party transactions,or disclosure about why the related party or its transactions are not included.In all such cases, the objectives described in paragraph .09 are relevant to theauditor.

Risk Assessment Procedures and Related Activities

Understanding the Entity’s Related Party Relationships and TransactionsDiscussion Among the Engagement Team (Ref: par. .13)

.A7 Matters that may be addressed in the discussion among the engage-ment team include the following:

• The nature and extent of the entity's relationships and transac-tions with related parties (using, for example, the auditor's recordof identified related parties updated after each audit)

• An emphasis on the importance of maintaining professional skep-ticism throughout the audit regarding the potential for mate-rial misstatement associated with related party relationships andtransactions

• The circumstances or conditions of the entity that may indicatethe existence of related party relationships or transactions thatmanagement has not identified or disclosed to the auditor (for ex-ample, a complex organizational structure, use of entities formed

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to accomplish specific purposes,22 or an inadequate informationsystem)

• The records or documents that may indicate the existence of re-lated party relationships or transactions

• The importance that management and those charged with gov-ernance attach to the identification of, appropriate accounting for,and disclosure of related party relationships and transactions andthe related risk of management override of relevant controls

.A8 In addition, the discussion in the context of fraud may include specificconsideration of how related parties may be involved in fraud. For example:

• Entities formed to accomplish specific purposes and that are con-trolled by management might be used to facilitate earnings man-agement.

• Transactions between the entity and a known business partnerof a key member of management could be arranged to facilitatemisappropriation of the entity's assets.

• As indicated in paragraph .A2, the form of a related party trans-action may mask its substance. For example, equity distributionsor capital contributions may be structured as loans.

• Related party transactions may be subject to period-end windowdressing. For example, a stockholder may pay a loan shortly beforeperiod-end, but the entity loans the same amount to the stock-holder shortly after period-end.

• Certain entities, such as governmental entities or entities operat-ing in regulated industries, may circumvent laws or regulationsthat limit or restrict their ability to engage in transactions withrelated parties.

The Identity of the Entity's Related Parties (Ref: par. .14a)

.A9 Information regarding the identity of the entity's related parties islikely to be readily available to management if the entity's information systemsrecord, process, and summarize related party relationships and transactions toenable the entity to meet applicable disclosure requirements. Therefore, man-agement may have a comprehensive list of related parties and changes fromthe prior period. For recurring engagements, making the inquiries specified byparagraph .14 provides a basis for comparing the information supplied by man-agement with the auditor's record of related parties noted in previous audits.

.A10 However, if the entity does not have such information systems inplace, management may not be aware of the existence of all related parties.Nevertheless, the requirement to make the inquiries specified by paragraph.14 still applies because management may be aware of parties that meet therelated party definition set out in GAAP. In such a case, however, the audi-tor's inquiries regarding the identity of the entity's related parties are likelyto form part of the auditor's risk assessment procedures and related activitiesperformed in accordance with section 315 to obtain information regarding thefollowing:23

• The entity's ownership and governance structures

22 Entities formed to accomplish specific purposes are discussed in paragraphs .A27–.A28 of sec-tion 315. [Footnote renumbered by the issuance of SAS No. 135, May 2019.]

23 Paragraph .12 of section 315. [Footnote renumbered by the issuance of SAS No. 135, May 2019.]

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• The types of investments that the entity is making and plans tomake

• The way the entity is structured and how it is financed

In the particular case of common control relationships, because managementis more likely to be aware of such relationships if they have economic signifi-cance to the entity, the auditor's inquiries are likely to be more effective if theyare focused on whether parties with which the entity engages in significanttransactions or shares resources to a significant degree are related parties.

.A11 In the context of a group audit, section 600, Special Considera-tions — Audits of Group Financial Statements (Including the Work of Compo-nent Auditors), requires the group engagement team to provide each componentauditor with information about related parties prepared by group managementand any other related parties of which the group engagement team is aware,including the nature of the entity's relationships and transactions with thoserelated parties.24 When the entity is a component within a group, this informa-tion provides a useful basis for the auditor's inquiries of management regardingthe identity of the entity's related parties. [As amended, effective for audits offinancial statements for periods ending on or after December 15, 2021, by SASNo. 135.]

.A12 The auditor also may obtain some information regarding the iden-tity of the entity's related parties through inquiries of management during theengagement acceptance or continuance process.

.A13 Section 580, Written Representations, addresses requirements to ob-tain management representations, including representations that manage-ment and, when appropriate, those charged with governance have25

a. disclosed to the auditor the identity of the entity's related partiesand all the related party relationships of which they are aware.

b. appropriately accounted for and disclosed such relationships andtransactions.

.A14 The inquiry about the identity of the entity's related parties mayinclude background information concerning the related parties, for example,physical location, industry, size, and extent of operations. [Paragraph added,effective for audits of financial statements for periods ending on or after De-cember 15, 2021, by SAS No. 135.]

.A15 Considerations specific to governmental entities. Because of the va-riety of the types of relationships and transactions among governmental andother entities, some of which are highly complex, identifying the nature of therelated party relationship and its appropriate treatment in the financial state-ments relies heavily on a governmental entity's application of its financial re-porting framework. Further, in some circumstances, the governmental entitymay have no legal jurisdiction over the related party even when the applica-tion of the financial reporting framework concludes that the related party'sfinancial statements are to be included in the governmental entity's financialstatements. In such cases, the auditor's inquiries regarding the identity of theentity's related parties are likely to include the concepts and guidance from the

24 Paragraph .40c of section 600, Special Considerations — Audits of Group Financial Statements(Including the Work of Component Auditors). [Footnote renumbered by the issuance of SAS No. 135,May 2019.]

25 Paragraph .17 of section 580, Written Representations. [Footnote renumbered by the issuanceof SAS No. 135, May 2019.]

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applicable financial reporting framework to assist in making appropriate as-sessments about the existence and nature of related party relationships. [Para-graph renumbered by the issuance of SAS No. 135, May 2019.]

The Entity's Controls Over Related Party Relationships and Transactions (Ref:par. .15)

.A16 Others within the entity are those considered likely to have knowl-edge of the entity's related party relationships and transactions and the entity'scontrols over such relationships and transactions, as well as the existence ofrelated parties or relationships or transactions with related parties previouslyundisclosed to the auditor, and whether such relationships or transactions werewith known or previously unknown related parties. These may include, to theextent that they do not form part of management, the following:

• Those charged with governance

• Personnel in a position to initiate, authorize, process, or record sig-nificant unusual transactions and those who supervise or monitorsuch personnel

• The internal audit function

• In-house legal counsel

• The chief ethics officer or equivalent person

• Chief compliance officer

• The human resources director or equivalent person

[As amended, effective for audits of financial statements for periods endingon or after December 15, 2014, by SAS No. 128. Paragraph renumbered andamended, effective for audits of financial statements for periods ending on orafter December 15, 2021, by SAS No. 135.]

.A17 The audit is conducted on the premise that management and, whenappropriate, those charged with governance have acknowledged and under-stand that they have responsibility for the preparation and fair presentationof the financial statements in accordance with the applicable financial report-ing framework and for the design, implementation, and maintenance of in-ternal control relevant to the preparation and fair presentation of financialstatements that are free from material misstatement, whether due to fraud orerror.26 Accordingly, the preparation of the financial statements requires man-agement, with oversight from those charged with governance, to design, im-plement, and maintain adequate controls over related party relationships andtransactions so that these are identified and appropriately accounted for anddisclosed. In their oversight role, those charged with governance monitor howmanagement is discharging its responsibility for such controls. Those chargedwith governance may, in their oversight role, obtain information from manage-ment to enable them to understand the nature and business purpose of theentity's related party relationships and transactions. [Paragraph renumberedand amended, effective for audits of financial statements for periods ending onor after December 15, 2021, by SAS No. 135.]

.A18 In meeting the requirement of section 315 to obtain an understand-ing of internal control, the auditor may consider features or elements relevantto mitigating the risks of material misstatement associated with related partyrelationships and transactions, such as the following:27

26 Paragraphs .05 and .A2 of section 200. [Footnote renumbered by the issuance of SAS No. 135,May 2019.]

27 Paragraph .13 of section 315. [Footnote renumbered by the issuance of SAS No. 135, May 2019.]

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• Internal ethical codes, appropriately communicated to the entity'spersonnel and enforced, governing the circumstances in which theentity may enter into specific types of related party transactions

• Policies and procedures for open and timely disclosure of the inter-ests that management and those charged with governance have inrelated party transactions

• The assignment of responsibilities within the entity for identify-ing, recording, summarizing, and disclosing related party transac-tions

• Timely disclosure and discussion between management and thosecharged with governance of related party transactions that arealso significant unusual transactions, including whether thosecharged with governance have appropriately challenged the busi-ness purpose of such transactions (for example, by seeking advicefrom external professional advisors)

• Clear guidelines for the approval of related party transactions in-volving actual or perceived conflicts of interest, such as approvalby a subcommittee of those charged with governance comprisingindividuals independent of management

• Periodic reviews by the internal audit function, when applicable

• Proactive action taken by management to resolve related partydisclosure issues, such as by seeking advice from the auditor orexternal legal counsel

• The existence of whistle-blowing policies and procedures, whenapplicable

[As amended, effective for audits of financial statements for periods endingon or after December 15, 2014, by SAS No. 128. Paragraph renumbered andamended, effective for audits of financial statements for periods ending on orafter December 15, 2021, by SAS No. 135.]

.A19 Controls over related party relationships and transactions withinsome entities may be deficient or nonexistent for a number of reasons, suchas the following:

• The low importance attached by management to identifying anddisclosing related party relationships and transactions

• The lack of appropriate oversight by those charged with gover-nance

• An intentional disregard for such controls because related partydisclosures may reveal information that management considerssensitive (for example, the existence of transactions involvingfamily members of management)

• An insufficient understanding by management of the applicablerelated party disclosure requirements

When such controls are ineffective or nonexistent, the auditor may be unable toobtain sufficient appropriate audit evidence about related party relationshipsand transactions. If this were the case, the auditor would, in accordance withsection 705, Modifications to the Opinion in the Independent Auditor's Report,consider the implications for the audit, including the opinion in the auditor'sreport. [Paragraph renumbered by the issuance of SAS No. 135, May 2019.]

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.A20 Fraudulent financial reporting often involves management overrideof controls that otherwise may appear to be operating effectively.28 The risk ofmanagement override of controls is higher if management has relationshipsthat involve control or significant influence with parties with which the en-tity does business because these relationships may present management withgreater incentives and opportunities to perpetrate fraud. For example, man-agement's financial interests in certain related parties may provide incentivesfor management to override controls by (a) directing the entity, against its in-terests, to conclude transactions for the benefit of these parties, or (b) colludingwith such parties or controlling their actions. Examples of possible fraud in-clude the following:

• Creating fictitious terms of transactions with related parties de-signed to misrepresent the business purpose of these transactions

• Fraudulently organizing the transfer of assets from or to manage-ment or others at amounts significantly above or below marketvalue

• Engaging in complex transactions with related parties, such as en-tities formed to accomplish specific purposes, that are structuredto misrepresent the financial position or financial performance ofthe entity

[Paragraph renumbered and amended, effective for audits of financial state-ments for periods ending on or after December 15, 2021, by SAS No. 135.]

.A21 Considerations specific to smaller entities. Control activities insmaller entities are likely to be less formal, and smaller entities may have nodocumented processes for dealing with related party relationships and transac-tions. An owner-manager may mitigate some of the risks arising from relatedparty transactions or potentially increase those risks through active involve-ment in all the main aspects of the transactions. For such entities, the auditormay obtain an understanding of the related party relationships and transac-tions, and any controls that may exist over these, through inquiry of manage-ment combined with other procedures, such as observation of management'soversight and review activities and inspection of available relevant documen-tation. [Paragraph renumbered by the issuance of SAS No. 135, May 2019.]

.A22 Authorization and approval of significant transactions and arrange-ments (Ref: par. .15b). Authorization involves the granting of permission by aparty or parties with the appropriate authority (whether management, thosecharged with governance, or the entity's shareholders) for the entity to enterinto specific transactions in accordance with predetermined criteria, whetheror not judgmental. Approval involves those parties' acceptance of the transac-tions the entity has entered into as having satisfied the criteria on which au-thorization was granted. Examples of controls the entity may have establishedto authorize and approve significant transactions and arrangements with re-lated parties or significant unusual transactions and arrangements outside thenormal course of business include the following:

• Monitoring controls to identify such transactions and arrange-ments for authorization and approval

• Approval of the terms and conditions of the transactions and ar-rangements by management, those charged with governance, or,when applicable, shareholders

28 Paragraph .31 of section 240. [Footnote renumbered by the issuance of SAS No. 135, May 2019.]

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[Paragraph renumbered and amended, effective for audits of financial state-ments for periods ending on or after December 15, 2021, by SAS No. 135.]

Remaining Alert for Related Party Information When ReviewingRecords or DocumentsRecords or Documents That the Auditor May Inspect (Ref: par. .17)

.A23 During the audit, the auditor may inspect records or documents thatindicate the existence of related party relationships or transactions that man-agement has not previously identified or disclosed to the auditor. Examples ofthose records or documents include the following:

• Third party confirmations obtained by the auditor (in addition tobank and legal confirmations)

• Entity income tax returns

• Information supplied by the entity to regulatory authorities

• Shareholder registers to identify the entity's principal sharehold-ers

• Statements of conflicts of interest from management and thosecharged with governance

• Records of the entity's investments and those of its benefit plans

• Contracts and agreements with key management or those chargedwith governance

• Significant contracts and agreements not in the entity's ordinarycourse of business

• Specific invoices and correspondence from the entity's professionaladvisors

• Life insurance policies acquired by the entity

• Significant contracts renegotiated by the entity during the period

• Reports of the internal audit function

• Capital financing arrangements with entities other than financialinstitutions (for example, construction of a governmental entityfacility associated with the issuance of debt by a related not-for-profit entity)

• Economic development arrangements for capital additions (for ex-ample, a governmental entity's use and eventual ownership ofproperties and facilities financed and operated by a company oranother governmental entity)

[As amended, effective for audits of financial statements for periods ending onor after December 15, 2014, by SAS No. 128. Paragraph renumbered by theissuance of SAS No. 135, May 2019.]

.A24 Additionally, the auditor may review the prior years' audit documen-tation for information about related party relationships and transactions. Ifapplicable, the auditor may inquire of a predecessor auditor about the prede-cessor's knowledge of existing relationships and the extent of management in-volvement in material transactions. [Paragraph renumbered by the issuance ofSAS No. 135, May 2019.]

.A25 Arrangements that may indicate the existence of previously unidenti-fied or undisclosed related party relationships or transactions. An arrangement

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involves a formal or informal agreement between the entity and one or moreother parties for such purposes as the following:

• The establishment of a business relationship through appropriatevehicles or structures

• The conduct of certain types of transactions under specific termsand conditions

• The provision of designated services or financial support

Examples of arrangements that may indicate the existence of related partyrelationships or transactions that management has not previously identifiedor disclosed to the auditor include the following:

• Participation in unincorporated partnerships with other parties

• Agreements for the provision of services to certain parties underterms and conditions that are outside the entity's normal courseof business

• Guarantees and guarantor relationships

[Paragraph renumbered by the issuance of SAS No. 135, May 2019.]Identification of Significant Unusual Transactions (Ref: par. .18)

.A26 Obtaining further information on significant unusual transactionsenables the auditor to evaluate whether fraud risk factors, if any, are presentand to identify the risks of material misstatement due to fraud. [Paragraphrenumbered and amended, effective for audits of financial statements for peri-ods ending on or after December 15, 2021, by SAS No. 135.]

.A27 Examples of transactions that may be significant unusual transac-tions include the following:

• Complex equity transactions, such as corporate restructurings oracquisitions

• Transactions with offshore entities in jurisdictions with less rig-orous corporate governance structures, laws, or regulations

• The leasing of premises or the rendering of management servicesby the entity to another party if no consideration is exchanged

• Sales transactions with unusually large discounts or returns

• Transactions with circular arrangements (for example, sales witha commitment to repurchase)

• Transactions under contracts whose terms are changed before ex-piration

[Paragraph renumbered and amended, effective for audits of financial state-ments for periods ending on or after December 15, 2021, by SAS No. 135.]

.A28 Understanding the nature of significant unusual transactions (Ref:par. .18a). Inquiring into the nature of the significant unusual transactionsinvolves obtaining an understanding of the business purpose of the transac-tions and the terms and conditions under which these have been entered into.29

[Paragraph renumbered and amended, effective for audits of financial state-ments for periods ending on or after December 15, 2021, by SAS No. 135.]

.A29 Inquiring into whether related parties could be involved (Ref: par..18b). A related party could be involved in a significant unusual transaction not

29 Paragraph .32c of section 240. [Footnote renumbered by the issuance of SAS No. 135, May2019.]

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only by directly influencing the transaction by being a party to the transactionbut also by indirectly influencing it through an intermediary. Such influencemay indicate the presence of a fraud risk factor. [Paragraph renumbered andamended, effective for audits of financial statements for periods ending on orafter December 15, 2021, by SAS No. 135.]

Sharing Related Party Information With the Engagement Team(Ref: par. .19 and .25a)

.A30 Relevant related party information shared with the engagementteam members may include the following:

• The nature of the related party relationships and transactions

• Significant or complex related party relationships or transactionsthat may require special audit consideration, particularly trans-actions in which management or those charged with governanceare financially involved

The exchange of information is most useful if made at an early stage of theaudit. [Paragraph renumbered by the issuance of SAS No. 135, May 2019.]

.A31 Section 600 addresses the communications that apply to group au-dits, particularly those that involve component auditors. [Paragraph renum-bered by the issuance of SAS No. 135, May 2019.]

Identification and Assessment of the Risks of MaterialMisstatement Associated With Related Party Relationshipsand Transactions

Fraud Risk Factors Associated With a Related Party With DominantInfluence (Ref: par. .21)

.A32 Related parties with the ability to exert control or significant influ-ence may be in a position to exert dominant influence over the entity or itsmanagement. Consideration of such behavior is relevant when identifying andassessing the risks of material misstatement due to fraud, as further explainedin paragraphs .A33–.A34. [Paragraph renumbered by the issuance of SAS No.135, May 2019.]

.A33 Domination of management by a single person or small group of per-sons without compensating controls is a fraud risk factor.30 Indicators of domi-nant influence exerted by a related party include the following:

• The related party has vetoed significant business decisions takenby management or those charged with governance.

• Significant transactions are referred to the related party for finalapproval.

• Little or no debate occurs among management and those chargedwith governance regarding business proposals initiated by the re-lated party.

• Transactions involving the related party (or a close family mem-ber of the related party) are rarely independently reviewed andapproved.

30 Paragraph .A76 of section 240. [Footnote renumbered by the issuance of SAS No. 135, May2019.]

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Dominant influence also may exist, in some cases, if the related party hasplayed a leading role in founding the entity and continues to play a leadingrole in managing the entity. [Paragraph renumbered by the issuance of SASNo. 135, May 2019.]

.A34 In the presence of other risk factors, the existence of a related partywith dominant influence may indicate significant risks of material misstate-ment due to fraud. For example

• an unusually high turnover of senior management or professionaladvisors may suggest unethical or fraudulent business practicesthat serve the related party's purposes.

• the use of business intermediaries for significant transactions forwhich there appears to be no clear business justification may sug-gest that the related party could have an interest in such trans-actions through control of such intermediaries for fraudulent pur-poses.

Evidence of the related party's excessive participation in, or preoccupation with,the selection of accounting policies or the determination of significant esti-mates may suggest the possibility of fraudulent financial reporting. [Paragraphrenumbered by the issuance of SAS No. 135, May 2019.]

Responses to the Risks of Material Misstatement AssociatedWith Related Party Relationships and Transactions (Ref: par. .22)

.A35 The nature, timing, and extent of the further audit procedures thatthe auditor may select to respond to the assessed risks of material misstate-ment associated with related party relationships and transactions depend uponthe nature of those risks and the circumstances of the entity. [Paragraphrenumbered by the issuance of SAS No. 135, May 2019.]

.A36 Examples of substantive audit procedures that the auditor may per-form when the auditor has assessed a significant risk that management hasnot appropriately accounted for or disclosed specific related party transactions(whether due to fraud or error) include the following:

• Confirming the business purposes, specific terms, or amounts ofthe transactions with the related parties (this audit proceduremay be less effective when the auditor judges that the entity islikely to influence the related parties in their responses to the au-ditor).

• Inspecting evidence in possession of the other party or parties tothe transaction.

• Confirming or discussing significant information with intermedi-aries, such as banks, guarantors, agents, or attorneys, to obtain abetter understanding of the transaction.

• Referring to financial publications, trade journals, credit agen-cies, and other information sources when there is reason to be-lieve that unfamiliar customers, suppliers, or other business en-terprises with which material amounts of business have beentransacted may lack substance.

• With respect to material uncollected balances, guarantees, andother obligations, evaluating information about the financial ca-pability of the other party or parties to the transaction. Suchinformation may be obtained from audited financial statements,

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unaudited financial statements, income tax returns, and reportsissued by regulatory agencies, taxing authorities, financial publi-cations, or credit agencies.

[Paragraph renumbered and amended, effective for audits of financial state-ments for periods ending on or after December 15, 2021, by SAS No. 135.]

.A37 If the auditor has assessed a significant risk of material misstate-ment due to fraud as a result of the presence of a related party with dominantinfluence, the auditor may, in addition to the general requirements of section240, perform audit procedures such as the following to obtain an understandingof the business relationships that such a related party may have establisheddirectly or indirectly with the entity and to determine the need for further ap-propriate substantive audit procedures:

• Inquiries of, and discussion with, management and those chargedwith governance

• Inquiries of the related party

• Inspection of significant contracts with the related party

• Appropriate background research, such as through the Internetor specific external business information databases

• Review of employee whistle-blowing reports when these are re-tained

[Paragraph renumbered by the issuance of SAS No. 135, May 2019.].A38 Depending upon the results of the auditor's risk assessment proce-

dures, the auditor may consider it appropriate to obtain audit evidence withouttesting the entity's controls over related party relationships and transactions.In some circumstances, however, it may not be possible to obtain sufficient ap-propriate audit evidence from substantive audit procedures alone, regardingthe risks of material misstatement associated with related party relationshipsand transactions. For example, when intragroup transactions between the en-tity and its components are numerous and a significant amount of informationregarding these transactions is initiated, authorized, recorded, processed, or re-ported electronically in an integrated system, the auditor may determine thatit is not possible to design effective substantive audit procedures that by them-selves would reduce the risks of material misstatement associated with thesetransactions to an acceptably low level. In such a case, in meeting the require-ment of section 330 to obtain sufficient appropriate audit evidence about theoperating effectiveness of relevant controls, the auditor is required to test theentity's controls over the completeness and accuracy of the recording of the re-lated party relationships and transactions.31 [Paragraph renumbered by theissuance of SAS No. 135, May 2019.]

Identification of Previously Unidentified or Undisclosed Related Parties orSignificant Related Party TransactionsCommunicating Newly Identified Related Party Information to the EngagementTeam (Ref: par. .25a)

.A39 Promptly communicating any newly identified related parties to theother members of the engagement team assists them in determining whetherthis information affects the results of, and conclusions drawn from, risk assess-ment procedures already performed, including whether the risks of material

31 Paragraph .08b of section 330. [Footnote renumbered by the issuance of SAS No. 135, May2019.]

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misstatement need to be reassessed. [Paragraph renumbered by the issuanceof SAS No. 135, May 2019.]

Substantive Procedures Relating to Newly Identified Related Parties or Signif-icant Related Party Transactions (Ref: par. .25d)

.A40 Examples of substantive audit procedures that the auditor may per-form relating to newly identified related parties or significant related partytransactions include the following:

• Making inquiries regarding the nature of the entity's relation-ships with the newly identified related parties, including inquir-ing of parties outside the entity who are presumed to have signif-icant knowledge of the entity and its business, such as legal coun-sel, principal agents, major representatives, consultants, guaran-tors, or other close business partners.

• Conducting an analysis of accounting records for transactionswith the newly identified related parties. Such an analysis maybe facilitated using computer assisted audit techniques.

• Verifying the terms and conditions of the newly identified relatedparty transactions and evaluating whether the transactions havebeen appropriately accounted for and disclosed.

[Paragraph renumbered by the issuance of SAS No. 135, May 2019.]

Intentional Nondisclosure by Management (Ref: par. .25f)

.A41 The requirements and guidance in section 240 regarding the audi-tor's responsibilities relating to fraud in an audit of financial statements arerelevant when management appears to have intentionally failed to disclose re-lated parties or significant related party transactions to the auditor. The au-ditor also may consider whether it is necessary to reevaluate the reliability ofmanagement's responses to the auditor's inquiries and management's repre-sentations to the auditor.32 [Paragraph renumbered by the issuance of SAS No.135, May 2019.]

Identified Related Party Transactions Required To Be Disclosed orDetermined to be a Significant RiskEvaluating the Business Purpose (Ref: par. .26a(i))

.A42 In evaluating the business purpose of a related party transaction thatis required to be disclosed in the financial statements or determined to be asignificant risk, the auditor may consider the following:

• Whether the transaction

— is overly complex (for example, it may involve multiple re-lated parties within a consolidated group)

— has unusual terms of trade, such as unusual prices, inter-est rates, guarantees, and repayment terms

— lacks an apparent logical business reason for its occur-rence

— involves previously unidentified related parties

— is processed in an unusual manner

32 Paragraphs .22–.24 and .26 of section 580. [Footnote renumbered by the issuance of SAS No.135, May 2019.]

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• Whether management has discussed the nature of, and account-ing for, such a transaction with those charged with governance

• Whether management is placing more emphasis on a particularaccounting treatment rather than giving due regard to the eco-nomic substance of the transaction

If management's explanations are materially inconsistent with the terms ofthe related party transaction, the auditor is required to consider the reliabilityof management's explanations and representations on other significant mat-ters.33 [Paragraph renumbered and amended, effective for audits of financialstatements for periods ending on or after December 15, 2021, by SAS No. 135.]

.A43 The auditor also may seek to understand the business purpose ofsuch a transaction from the related party's perspective because this may helpthe auditor to better understand the economic substance of the transaction andwhy it was carried out. A business purpose from the related party's perspectivethat appears inconsistent with the nature of its business may represent a fraudrisk factor. [Paragraph renumbered and amended, effective for audits of finan-cial statements for periods ending on or after December 15, 2021, by SAS No.135.]

Authorization and Approval of Significant Related Party Transactions (Ref: par..26b)

.A44 Authorization and approval by management, those charged with gov-ernance, or, when applicable, the shareholders of related party transactionsthat are required to be disclosed in the financial statements or determined tobe a significant risk may provide audit evidence that these have been duly con-sidered at the appropriate levels within the entity, and that their terms andconditions have been appropriately reflected in the financial statements. Theexistence of transactions of this nature that were not subject to such authoriza-tion and approval, in the absence of rational explanations based on discussionwith management or those charged with governance, may indicate risks of ma-terial misstatement due to fraud or error. In these circumstances, the auditormay need to be alert for other transactions of a similar nature. Authorizationand approval alone, however, may not be sufficient in concluding whether risksof material misstatement due to fraud are absent because authorization andapproval may be ineffective if there has been collusion between the relatedparties or if the entity is subject to the dominant influence of a related party.[Paragraph renumbered and amended, effective for audits of financial state-ments for periods ending on or after December 15, 2021, by SAS No. 135.]

.A45 Considerations specific to smaller entities. A smaller entity may nothave the same controls provided by different levels of authority and approvalthat may exist in a larger entity. Accordingly, when auditing a smaller entity,the auditor may rely to a lesser degree on authorization and approval for auditevidence regarding the validity of related party transactions that are requiredto be disclosed in the financial statements or determined to be a significant risk.Instead, the auditor may consider performing other audit procedures, such asinspecting relevant documents, confirming specific aspects of the transactionswith relevant parties, or observing the owner-manager's involvement with thetransactions. The discussion of management domination in paragraph .A33 andthe fraud considerations discussed in paragraph .A8 provide further relevantguidance. [Paragraph renumbered and amended, effective for audits of financialstatements for periods ending on or after December 15, 2021, by SAS No. 135.]

33 Paragraph .10 of section 500A, Audit Evidence. [Footnote renumbered by the issuance of SASNo. 135, May 2019.]

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Assertions That Related Party Transactions Were Conducted on TermsEquivalent to Those Prevailing in an Arm’s Length Transaction (Ref: par. .27)

.A46 It will generally not be possible to determine whether a particulartransaction would have taken place if the parties had not been related or, as-suming it would have taken place, what the terms and manner of settlementwould have been. Accordingly, it is difficult to substantiate representations thata transaction was consummated on terms equivalent to those that prevail inarm's length transactions. [Paragraph renumbered by the issuance of SAS No.135, May 2019.]

.A47 Although audit evidence may be readily available regarding how theprice of a related party transaction compares to that of a similar arm's lengthtransaction, practical difficulties ordinarily limit the auditor's ability to obtainaudit evidence that all other aspects of the transaction are equivalent to thoseof the arm's length transaction. For example, although the auditor may be ableto confirm that a related party transaction has been conducted at a marketprice, it may be impracticable to confirm whether other terms and conditionsof the transaction (such as credit terms, contingencies, and specific charges)are equivalent to those that would ordinarily be agreed between independentparties. Accordingly, there may be a risk that management's assertion that arelated party transaction was conducted on terms equivalent to those prevail-ing in an arm's length transaction may be materially misstated. [Paragraphrenumbered by the issuance of SAS No. 135, May 2019.]

.A48 The preparation and fair presentation of the financial statements re-quires management to substantiate an assertion included in financial state-ments that a related party transaction was conducted on terms equivalent tothose prevailing in an arm's length transaction, giving appropriate considera-tion to the difficulties described in paragraphs .A46–.A47. Management's sup-port for the assertion may include the following:

• Comparing the terms of the related party transaction to those ofan identical or similar transaction with one or more unrelated par-ties

• Engaging an external specialist to determine a market value andconfirm market terms and conditions for the transaction

• Comparing the terms of the transaction to known market termsfor broadly similar transactions on an open market

[Paragraph renumbered by the issuance of SAS No. 135, May 2019.]

.A49 Evaluating management's support for this assertion may involve oneor more of the following:

• Considering the appropriateness of management's process forsupporting the assertion

• Verifying the source of the internal or external data supportingthe assertion and testing the data to determine their accuracy,completeness, and relevance

[Paragraph renumbered by the issuance of SAS No. 135, May 2019.]

.A50 If the auditor believes that management's assertion is unsubstanti-ated or the auditor cannot obtain sufficient appropriate audit evidence to sup-port the assertion, the auditor, in accordance with section 705, considers theimplications for the audit, including the opinion in the auditor's report. [Para-graph renumbered by the issuance of SAS No. 135, May 2019.]

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Evaluation of the Accounting for, and Disclosure of, IdentifiedRelated Party Relationships and Transactions

Materiality Considerations in Evaluating Misstatements (Ref: par. .28).A51 Section 450, Evaluation of Misstatements Identified During the Au-

dit, requires the auditor to consider both the size and nature of a misstatementand the particular circumstances of its occurrence when evaluating whetherthe misstatement is material.34 The significance of the transaction to the fi-nancial statement users may not depend solely on the recorded amount of thetransaction but also on other specific relevant factors, such as the nature of therelated party relationship. [Paragraph renumbered by the issuance of SAS No.135, May 2019.]

Evaluation of Related Party Disclosures (Ref: par. .28a).A52 Evaluating the related party disclosures means considering whether

the facts and circumstances of the entity's related party relationships andtransactions have been appropriately summarized and presented so that thedisclosures are understandable. Disclosures of related party transactions maynot be understandable if

a. the business purpose and the effects of the transactions on thefinancial statements are unclear or misstated.

b. key terms, conditions, or other important elements of the trans-actions necessary for understanding them are not appropriatelydisclosed.

[Paragraph renumbered and amended, effective for audits of financial state-ments for periods ending on or after December 15, 2021, by SAS No. 135.]

Communication With Those Charged With Governance(Ref: par. .29)

.A53 Communicating significant findings or issues arising during the au-dit in connection with the entity's related parties helps the auditor establish acommon understanding with those charged with governance of the nature andresolution of these matters.35 Examples of significant related party findings orissues include the following:

• Nondisclosure (whether or not intentional) by management to theauditor of related parties or significant related party transactions,which may alert those charged with governance to significant re-lated party relationships and transactions of which they may nothave been previously aware

• The identification of significant related party transactions thathave not been appropriately authorized and approved, which maygive rise to suspected fraud

• The identification of significant related party transactions thatappear to lack a business purpose

34 Paragraph .11a of section 450, Evaluation of Misstatements Identified During the Audit. [Foot-note renumbered by the issuance of SAS No. 135, May 2019.]

35 Paragraph .A10 of section 230 provides further guidance on the nature of significant findingsor issues arising during the audit. [Footnote renumbered by the issuance of SAS No. 135, May 2019.]

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• Disagreement with management regarding the accounting for,and disclosure of, significant related party transactions

• The inclusion of a statement in the financial statements that atransaction with a related party was conducted on terms equiva-lent to those prevailing in an arm's-length transaction

• Noncompliance with applicable laws or regulations prohibiting orrestricting specific types of related party transactions

• Difficulties in identifying the party that ultimately controls theentity

[Paragraph renumbered and amended, effective for audits of financial state-ments for periods ending on or after December 15, 2021, by SAS No. 135.]

©2021, AICPA AU-C §550.A53